Liberty. It’s a simple idea, but it’s also the linchpin of a complex system of values and practices: justice, prosperity, responsibility, toleration, cooperation, and peace. Many people believe that liberty is the core political value of modern civilization itself, the one that gives substance and form to all the other values of social life. They’re called libertarians.

Tuesday, July 10, 2012

Fractional Reserve Banking, Government and Moral Hazard

– by Ron Paul

Ron Paul

Last week my subcommittee held a hearing on fractional reserve banking
and the moral hazard created by government (taxpayer) insured deposits.
Fractional reserve banking is the practice by which banks accept
deposits but only keep a fraction of those deposits on hand at any time.
In practice, nearly 100% of deposits are loaned out, yet depositors
believe that they can withdraw the full amount of their deposit at any
time. Loaned funds are then redeposited and reloaned up to the limit of
the bank's reserve requirements, compounding the effect.
As Murray Rothbard
put it, "Fractional reserve banks ... create money out of thin air.
Essentially they do it in the same way as counterfeiters.
Counterfeiters, too, create money out of thin air by printing something
masquerading as money or as a warehouse receipt for money. In this way,
they fraudulently extract resources from the public, from the people who
have genuinely earned their money. In the same way, fractional reserve
banks counterfeit warehouse receipts for money, which then circulate as
equivalent to money among the public. There is one exception to the
equivalence: The law fails to treat the receipts as counterfeit."
While mainstream economists extol this "money multiplier" as a nearly
miraculous process that results in a robust economy, low reserve
requirements actually enable banks to create trillions of dollars of
credit out of thin air, a process that distorts the structure of
production and gives rise to the business cycle.
Once the boom phase of the business cycle has run its course and the
bust commences, some people will naturally look to hold cash. So they
withdraw money from their bank accounts in order to hold physical
currency. But bank deposits consist of a huge amount of credit pyramided
on top of a small of amount of original cash deposits. Each dollar of
cash that is withdrawn unwinds the multiplier, resulting in a
contraction in credit. And if depositors en masse attempt to withdraw
more funds than are available in reserves, the entire of house of cards
comes crashing down. This is the very real threat facing some European
banks today.
Since the amount of deposits always exceeds the amount of reserves,
it is obvious that fractional reserve banks cannot possibly pay all of
their depositors on demand as they promise – thus making these banks
functionally insolvent. While the likelihood of all depositors pulling
their money out at once is relatively rare, bank runs periodically do
occur. The only reason banks are able to survive such occurrences is
because of the government subsidy known as deposit insurance, which was
intended to backstop the stability of the banking system and prevent
bank runs. While deposit insurance arguably has succeeded in reducing
the number and severity of bank runs, deposit insurance is still an
explicit bailout guarantee. It thereby creates a moral hazard by
encouraging bank deposits into fundamentally unsound financial
institutions and contributes to instability in the financial system.
The solution to the problem of financial instability is to establish a
truly free-market banking system. Banks should no longer have a
government backstop of any sort in the event of failure. Banks, like
every other business, should have to face the spectre of market
regulation. Those banks which engage in sound business practices, keep
adequate reserves on hand, and gain the confidence of their customers
will survive, while others fall by the wayside.
Banking, like any other financial activity, is not without risk – and
the government should not continue its vain and futile pursuit of
trying to eliminate risk. Get government out of the way and allow the
market to function. This will result in a more stable system that meets
the needs of consumers, borrowers, and investors.